How comfortable a retirement income could a £1.25m pension pot actually get you?

Life of luxury: We explain how far a £1.25million pension pot will get you.

How big will my retirement income be if my pension pot ever manages to reach the soon-to-be-introduced tax-free lifetime allowance limit of £1.25 million?

Adam Uren, of This is Money, says: The pensions industry has been frantically checking calculators since George Osborne announced major changes to tax relief on pensions in his Autumn Statement earlier this month.

The reduction of the lifetime allowance from £1.5million to £1.25million, due to come into force in April 2014, will mean savers will have to pay a hefty tax charge (55 per cent if taken as lump sum, 25 per cent if taken as income) on every pound above £1.25million their pension pot is valued at.

Up until this point, they will receive tax relief on their pension contributions, so if you are a higher rate taxpayer, for every 60p you put into a pension, the Government will top it up to £1.

How much £1.25million will translate to in terms of retirement income naturally depends upon an individual's circumstances, the kind of pension they are in, what stipulations they want to place, say, on an annuity, and other variables such as medical history, the age of their spouse and where they live.

Though saving £1.25million into a pension pot is beyond the reach of the vast majority of workers, the pot might not guarantee as much income as you'd think.

The change to the lifetime allowance has also thrown once more into the spotlight the major difference in income generated between a defined contribution pension, such as a money purchase scheme, and a defined benefits pension, such as lucrative final salary schemes.

I had hoped to write this column up with a simple, 'have a £1.25m pot? This is what you can expect at retirement' line, but as you will see below, and as anyone who has ever dealt with pensions will know, it's never that simple.

Annuity headache: Calculating possible incomes from an annuity is incredibly complicated and depends on a large number of variables.

What you could get if you buy an annuity

For pension savers on workplace defined contribution pensions, where contributions from you and your employer are put into a pot and then invested, in all likelihood you will buy an annuity with your pension fund.

The same goes for those with personal pensions such as a Self-Invested Personal Pension (Sipp).

In the immediate aftermath of the Autumn Statement, This is Money reported that for a 65-year-old with a spouse two years younger with a lifetime annuity that rises with inflation could expect an income of £41,000 at best from a £1.25million pot, based on calculations by Tim Stalkartt, head of financial planning at Bestinvest.

This amount might seem quite low compared to the value of a £1.25million pension pot, and pales in comparison to what a final salary scheme would generate with a value of £1.25million (see below).

But in fact, tweak the circumstances and the annual income could be even lower than this, particularly at today's annuity rates.

Rob Burgeman, divisional director at Brewin Dolphin Investment Management, found that for someone retiring at 65 looking for a 50% joint life annuity (half the income continues to be paid to their spouse upon pension holder's death) with a fixed rate that sees the income rise 3% each year (annual uplift), the best buy annuity would get you an income of £37,887.

A final salary scheme member with 40 years' service on a 1/60th scheme would get this amount when retiring on £56,831 and someone with 30 years' service would get it at just over £75,000, but anyone not on a defined benefits pension would have to be earning far more to accrue a £1.25million pension pot.

Annuity provider Aegon meanwhile has calculated even lower annual incomes based on other variables when a 65-year-old with a spouse three years younger retires - based on its own rates.

A 100% joint life annuity (full income continues to be paid to spouse upon pension holder's death), with no lump sum or guaranteed period, and a 3% annual uplift would give you an income of just £28,550.

This would rise to £33,016 if it was a 50% joint life annuity.

LV does not provide the standard lifetime annuities, but fixed-term annuities which guarantees an income over a certain period of time.

This is likely to generate a higher income amount, but would leave you having to find another source for your retirement income once the term ends.

Based on a 65-year-old with a spouse three years younger buying a 50% joint life annuity over a fixed term of 20 years, the yearly income would be £66,250 provided you do not take a tax-free lump sum.

Should you take the lump sum, the income would reduce to £49,687.

Meanwhile, Aviva said that it quotes special terms for pots over a value of £1 million, and that for a 100% joint life annuity where the spouses have the same dates of birth, and neither have lifestyle factors of medical conditions that would lead to an enhanced rate, the income it would provide for £1.25million would be £42,698.44.

For a single-life policy for a person aged 65, a £1.25million pension fund value with 3 per cent escalation, again with no lifestyle or health factors, would provide an annuity rate of £51,426.12.

Drawdown hit: Brian and Marianne Jones from Shropshire were hit by the income drawdown changes.

How much you could get through income drawdown

Rather than buying an annuity with your pension fund you could take an income by drawing directly from your pension pot, which would stay invested and grow or contract depending on the performance of the investments.

The proportion of your pension pot you can draw down each year is calculated based on Government Actuary's Department (GAD) rate.

These rules dictate that the maximum annual income should be linked to the prevailing yield on a 15-year gilt – the ‘GAD’ rate – at the time income is first drawn. The income is then set in stone until it is next reviewed after three years.

The Government caused uproar in April 2011 when it cut the amount a pension holder could draw down from 120 per cent of the GAD rate to 100 per cent of the GAD rate.

Following a sustained campaign led by the Financial Mail, George Osborne reversed the decision in the Autumn Statement and the 120 per cent rate will return at an as yet undetermined date.

Using the Hargreaves Lansdown pension income drawdown calculator, a £1.25million pension pot would provide a drawdown income of £49,687.50, assuming a maximum GAD rate of 5.3 per cent.

If this was taken when the 120 per cent rate returns, this would increase to £59,625.

One of the drawbacks of drawdown however is that it does not guarantee an income for life, and that pensioners run the risk of depleting their pension funds.

New allowance limit: GPs and other doctors in final salary schemes could be hit by the new lifetime allowance tax relief changes.

What you would get with a final salary pension

There is more consensus, due to the way it is calculated, as to the maximum income in retirement you can get from a final salary scheme before hitting the £1.25million tax-free ceiling.

At £62,500, this is already significantly higher than those provided by the annuities above, and it is the gold-plated nature of these pensions which is why the vast majority are now closed to new members.

This is a defined benefit pension, so an employee will be guaranteed a certain level of income upon retirement, which is calculated based on a proportion of their final salary multiplied by their years of service with the company.

As there is no 'pension pot' accrued with this kind of scheme, to measure it against the lifetime allowance limit of £1.25million, the yearly benefit is multiplied by 20.

So £62,500 multiplied by 20 is £1.25million. If someone is entitled to a retirement income through final salary which is higher than £62,500, they will be hit with tax charges on money above that amount.

How much you need to earn to get a £62,500 pension depends on how much service you have accrued and the type of scheme.

HMRC allows people to take an income the equivalent of two-thirds of their final salary.

Taking the standard 1/60th scheme (where you are given a 1/60th of your salary upon retirement for each year of service), you would get a £62,500 retirement income with 40 years' service on a final salary of £93,750.

If you had 30 years' service on a 1/60th scheme you would need to be earning £125,000 upon retiring; while with 20 years this figure would be £187,500.

Lucrative final salary schemes may well be, but the reduction in the lifetime allowance to £1.25m has come under-fire as it will not only affect the super rich.

While only the extremely wealthy should be able to accrue a defined contribution or personal pension pot worth £1.25million; the nature of final salary schemes means that along with some long-standing executives and senior managers, GPs, headteachers and local government directors could conceivably be dragged into higher tax on their pensions.

Still, they won't be too badly off. The £33,016 provided by Aegon as a possible annuity level could be achieved with 40 years service while retiring on a final salary of £49,524, with the total pension fund not coming close to the lifetime allowance as it would be valued at £990,480, more than £250,000 lower than a private pension would be valued at, but providing the same income.her.